3.2 Ratio Analysis and Earning Quality Flashcards
Limitations of Ratio Analysis
- Accounting rules
- accounting policies
- historical cost
- estimates
- Manipulation
- Inflation
- Time Frames
- Changes in management
A company could negatively affect its earnings quality if it frequently
A. Constructed plants in countries with unstable currency.
B. Invested long-term in an erratic stock or bond market.
C. Materially changed accounting estimates.
D. Offered significant sales discounts.
C. Materially changed accounting estimates.
Which one of the following actions undertaken by a technology company’s management will adversely impact the quality of its earnings?
A. Using conservative estimates for the useful life of the company’s equipment.
B. Recording sales of software prior to installation and acceptance by customers.
C. Immediately expensing product research and development costs.
D. Estimating a low rate of return on the company’s pension plan assets.
B. Recording sales of software prior to installation and acceptance by customers.
Earnings quality is defined as a measure of how useful reported earnings are as a performance indicator. Consistency of earnings is an aspect of quality, as is the use of conservative estimates for the useful life of the company’s equipment. Any accounting principle that is conservative with respect to reporting earnings is considered an aspect of quality, e.g., immediately expensing product R&D costs. Also, estimating a low return on the company’s pension plan assets will increase pension expense, which leads to a more conservative income statement and a higher quality of earnings. Recording sales of software prior to installation and acceptance by a customer does not comply with generally accepted revenue recognition principles and consequently would adversely affect the quality of earnings.
A chief financial officer has been tracking the activities of the company’s nearest competitor for several years. Among other trends, the CFO has noticed that this competitor is able to take advantage of new technology and bring new products to market more quickly than the CFO’s company. In order to determine the reason for this, the CFO has been reviewing the following data regarding the two companies:
Company / Competitor
Accounts receivable turnover 6.85 / 7.35
Return on assets 15.34 / 14.74
Times interest earned 15.65 / 12.45
Current ratio 2.11 / 1.23
Debt/equity ratio 42.16 / 55.83
Degree of financial leverage 1.06 / 1.81
Price/earnings ratio 26.56 / 26.15
On the basis of this information, which one of the following is the best initial strategy for the CFO to follow in attempting to improve the flexibility of the company?
A. Seek cost cutting measures that would increase the company’s profitability.
B. Investigate ways to improve asset efficiency and turnover times to improve liquidity.
C. Seek additional sources of outside financing for new product introductions.
D. Increase the company’s investment in short-term securities to increase the current ratio.
C. Seek additional sources of outside financing for new product introductions.
The company’s times interest earned, debt/equity ratio, and degree of financial leverage all reveal that the company is less leveraged than its competitor. The two firms’ price-earnings ratios are comparable, so the company should be able to raise new capital fairly easily, either debt or equity. Thus, the company should seek additional sources of outside financing for new product introductions.
The key difference between accounting profit and economic profit is that economic profit
A. Highlights the historical cost concept.
B. Calculates changes in supply using EOQ models.
C. Excludes income tax and interest expense.
D. Considers the opportunity cost of equity.
D. Considers the opportunity cost of equity.
Economic profit is the excess of revenues over explicit and implicit costs. Implicit costs include opportunity costs. Accounting profit, however, does not account for implicit costs.
